We all want to invest, but there is a point at which we are often undecisive of the amount of allocation to give to one type of asset. Typically, the assets available are - Equity, Fixed Income, Gold, Real estate, etc. We are, however, only going to focus on two asset classes - Equity and Fixed Income.
Asset allocation is one of the most critical factors contributing to your financial freedom. Asset allocation helps you generate the expected returns and give a little protection on the downside. Asset allocation varies from investor to investor, and there are a lot of factors contributing to this - age, marital status, location, lifestyle, children, income, and goals, to name a few.
In this article, we will be discussing three methods of asset allocation -
1. Allocation based on maximum loss percentage
2. Allocation based on age
3. Allocation for senior citizens
Allocation based on maximum loss percentage:
As the name suggests, this method is based on the maximum possible loss you can bear without causing emotional and financial distress. Risk appetite varies from person to person. This method quantitatively helps you decide your portfolio's asset allocation and is a very effective method.
Maximum loss can vary from person to person. It may be 10% for a few, while for some, it may be 75%. The formula for max loss percentage is:
Allocation in equity = (Max loss% + Rf rate) / (Max market loss% + Rf rate)
Note: Rf - Risk-Free Rate
What exactly is the maximum market loss? Maximum market loss is the highest possible loss that can occur in the market. This is generally an average of all the biggest stock market crises. For example, in 2008, the BSE Index saw a sharp fall of 61%. This can be considered as the maximum loss % in the above formula.
Allocation based on age:
This is more commonly known as the rule of 100. If you don't want to work out many details, you can ideally use this method to estimate your allocation of assets.
All you need to do is subtract your age from 100. That is the % of allocation you should ideally have for equities. For example, if X is 33 years old, he should have 67% (100% - 33%) towards equities and 33% towards debt. This concept works on the basic fundamental assumption that as you grow older, your risk appetite reduces. However, this may not always work because there is a possibility of a 50-year-old man having a high-risk appetite. In those scenarios, the above formula should be used.
There is a different school of thought regarding the rule of 100. Experts say that using this rule gives out sub-optimal allocation in equities during the retirement years. They say that longevity has increased, and retired lives have become longer. So, longer retired lives combined with inflation required a higher allocation towards equities. To tackle this, they came out with the rule of 120.
The same procedure is followed here, but instead of subtracting from 100, you subtract it from 120.
Allocation for senior citizens:
This is more commonly known as the "Sleep peacefully strategy". Suppose you are about to retire or have already retired. Let's assume that your retired life will be 20 years, and your yearly expenses are 15 lakhs. For this strategy, you will invest Rs. 1.5 crores in a low-risk fixed-income instrument.
How did we come to the figure of Rs. 1.5 crores? You ideally take half of your retired life and multiply it with the annual expenses, i.e. (10 years x 15 lakh). Here we will assume that the returns from the fixed income instrument beat the inflation. Using this, you will be able to make withdrawals for the next 10 years and end up with a little extra amount because of the compounding effect.
The big question is whether this strategy can sustain us for only half of our retired life. How will we manage the rest? This is when equity investments come into play. For the first 10 years of your retirement, you don't have to rely on the money in equities and let the equities create wealth for you. If you invest an amount equal to expenses of around 2-3 years, for the next 10 years, you can ideally survive in that. (A proper calculation is based on the return from equity markets and the inflation rate. For this, we will be posting a separate article showing how to go about this calculation).
This strategy is so effective as you invest a little amount in equity for the initial years and let it create wealth for you while you sustain your debt investments. However, if the markets don't perform as expected, you may not be successful in this strategy. There is always a component of risk attached; hence a contingent fixed income fund must be created for unforeseen circumstances.
The strategies discussed above can be used to decide your allocation in debt and equity. Moreover, it would help if you also kept in mind that rebalancing your portfolio from time to time is very important. Rebalancing it annually is a bad idea; however, you can consider rebalancing your portfolio once in 2-3 years.
Please feel free to contact us for more details regarding the above strategies, calculations, and methodologies.